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The Great Leverage 2.0? a Tale of Different Indicators of Corporate Leverage Falk Bräuning and J

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The Great Leverage 2.0? a Tale of Different Indicators of Corporate Leverage Falk Bräuning and J Research Department April 2, 2020 Current Policy Perspectives The Great Leverage 2.0? A Tale of Different Indicators of Corporate Leverage Falk Bräuning and J. Christina Wang Many policymakers have expressed concerns about the rise in nonfinancial corporate leverage and the risks this poses to financial stability, since (1) high leverage raises the odds of firms becoming a source of adverse shocks, and (2) high leverage amplifies the role of firms in propagating other adverse shocks. This policy brief examines alternative indicators of leverage, focusing especially on the somewhat disparate signals they send regarding the current state of indebtedness of nonfinancial corporate businesses. Even though the aggregate nonfinancial corporate debt-to-income ratio is at a historical high, these firms’ ability to service the debt, as measured by the interest coverage ratio, looks healthy. A simple model shows that this pattern can be consistent with firms’ optimal choice of leverage in response to an exogenous decline in interest rates. On the other hand, the model also reveals that the fall in the interest coverage ratio due to a given yield increase is magnified when interest rates are at low levels. The implication is that the elevated nonfinancial corporate debt-to-income ratio that has been present in recent years raises the downside risk of firms becoming unable to service their debt following any adverse shock, such as a decline in income or an increase in risk premia. 1. Introduction In recent years, US policymakers have repeatedly expressed concerns about the rising leverage of nonfinancial corporate businesses and the risks this poses to financial stability and the real economy. A natural question is just how high this leverage is by historical standards: Is it so far beyond the historical norm as to be alarming? Several alternative metrics are used to measure leverage, and it turns out bostonfed.org Current Policy Perspectives | The Great Leverage 2.0? A Tale of Different Indicators of Corporate Leverage they tell somewhat different stories. Using aggregate data from the Financial Accounts of the United States (formerly known as the Flow of Funds), this policy brief reviews some of the most commonly used measures, focusing on the distinctions across these leverage measures and how they have evolved differently over time. The goal is to distill an overall coherent story regarding what the current state of the debt levels carried by US nonfinancial corporations may imply about risks to financial and economic stability. Specifically, in this brief we examine three alternative measures of leverage. The first is the metric most often used to gauge corporate leverage: debt over gross domestic product (GDP).1 For example, in his speech on September 20, 2019, Federal Reserve Bank of Boston President Eric S. Rosengren highlighted the increase in the debt-to-GDP ratios seen in the leveraged-loan market segment. More broadly, in May 2019, Federal Reserve Board Chairman Jerome H. Powell underscored the general increase in the debt-to-GDP ratio in the business sector.2 Debt over GDP compares the stock of debt with the flow of income. To more directly gauge a firm’s ability to service its debt, we use a second leverage measure based entirely on flow variables, specifically the ratio of income to interest payments, which is generally referred to as the interest coverage ratio (ICR). The higher this ratio is, the more able a firm is to cover interest expenses out of its current income, and hence the lower the firm’s effective leverage is. In corporate finance, leverage is often measured using the value of debt over assets, which is a ratio between two stock measures. This third measure can be regarded as the capitalized version of the (inverted) flow-based measure. Our basic finding is that even though the nonfinancial corporate debt-to-GDP ratio has been at a historical high in recent years, the levels of the other two leverage ratios seem to be far less alarming. During the same period that the debt-to-GDP ratio has risen, the debt-to-asset ratio has hovered around its longer- term (since the 1960s) average. Furthermore, the current ICR is above the historical mean over the past few decades. We show that this overall pattern is consistent with the interpretation that US firms have optimally increased their amount of debt relative to income in response to an exogenous secular decline in interest rates. We illustrate this mechanism using a simple stylized model. On the other hand, this model also demonstrates that, all else being equal, a higher debt-to-income ratio renders a firm more vulnerable to a given (percentage point) increase of the corporate debt yield, since its interest payments will rise by a larger proportion relative to its income. 1 At the individual firm level, leverage is often measured as debt over earnings before interest, tax, depreciation, and amortization. 2 These two speeches can be accessed, respectively, at https://www.bostonfed.org/news-and- events/ speeches/2019/assessing-economic-conditions-and-risks-to-financial-stability.aspx and https://www. federalreserve.gov/newsevents/speech/powell20190520a.htm. Federal Reserve Bank of Boston | bostonfed.org | Research Department 2 Current Policy Perspectives | The Great Leverage 2.0? A Tale of Different Indicators of Corporate Leverage One potential trigger for an increase in a firm’s interest rate is a spike in the credit-risk premium (risk spread) during a so-called risk-off scenario, where debt investors suddenly pull back on their investment in risky assets, possibly due to a capital or funding shock. Credit spreads also tend to rise when the economy is hit by negative shocks, which can take the form of a regular recession or unforeseen rare events such as the coronavirus outbreak that has swept across the globe since January 2020. A widening in credit spreads in such cases reflects a perceived increase in default (credit) risk as cash inflow falters, possibly exacerbated by a deterioration in market liquidity. Obviously, during such a downturn, firm income falls as a result of the contraction in economic activity. In fact, any disruption to income is seriously detrimental whenever a firm’s creditworthiness depends primarily on its ability to service its debt payment, as evidenced by the fallout from the coronavirus outbreak. A reduction in income combined with a spike in credit spreads can lead to precipitous falls in the ICR. It is conceivable that this dynamic could lead to a vicious feedback loop that sees the credit spread spiraling up, as an acute decline in the ICR makes ratings downgrades or technical defaults more likely, which may then induce a flight to safe assets, raising risk spreads and further depressing the ICR. In sum, the implication is that, even with a healthy current ICR, the historically high debt-to- income ratio raises the downside risk to the ICR, which could decline precipitously in a downturn.3 In fact, even controlling for the level, today’s high debt-to-income ratio likely poses greater risk to the economy than it did during past business cycles. One aggravating factor is the historically high share of BBB (the lowest investment grade) bonds, a situation that inevitably increases the expected number of downgrades of BBB bonds to high-yield bonds should a downturn occur. This in turn raises the likelihood of a flight to safety and possibly the tail risk of fire sales, in particular, because some investors face restrictions on or increased costs of holdings of high-yield debt, resulting in a reduction of supply of funding and a credit crunch. Another reason for the higher risk is that monetary policy is more constrained in this era of low real and nominal interest rates. As a result, the reduction in risk-free rates brought about by traditional monetary policy easing is more limited and can be easily overwhelmed by spikes in the credit risk spread.4 In short, there are reasons to suspect that the downside risk due to the currently high nonfinancial corporate debt-to-income ratio is much heightened in today’s world despite the still solid ICR. 3 In general, corporate borrowing costs also may rise if monetary policy rates increase in response to a booming economy, although in this case corporate earnings likely would remain strong, thus posing less of a risk to financial stability. 4 The FOMC quickly cut the fed funds rate to zero on March 15, 2020, after an earlier cut on March 3, 2020, in response to the sharply negative economic impact of the coronavirus outbreak. This means that the Fed will have to rely on unconventional policy tools to provide additional stimulus. Federal Reserve Bank of Boston | bostonfed.org | Research Department 3 Current Policy Perspectives | The Great Leverage 2.0? A Tale of Different Indicators of Corporate Leverage The rest of the analysis is organized as follows. We study aggregate US data for nonfinancial corporate leverage, then offer a stylized model that can rationalize the overall pattern observed in data. Finally, we discuss the potential policy implications and conclude. 2. Three Different Aggregate Measures of Nonfinancial Business Leverage The Financial Accounts of the United States divides nonfinancial US businesses into two sectors—corporate and noncorporate—and reports statistics for them separately. The corporate sector is materially larger than the noncorporate sector. The total assets of the noncorporate sector fell from about 60 percent of the corporate sector in 1960 to a nadir of 38 percent in the fourth quarter of 2000, and has since recovered to nearly 50 percent. Naturally, more emphasis is placed on the corporate sector because of its larger size. Moreover, data availability limits micro analysis at the firm level to the corporate sector.
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